The dollar's perfect storm worsens

By Jim Jubak

On Nov. 13, I wrote that the U.S. dollar was being pummeled by a perfect storm. Just three weeks later, the storm is even stronger. The force of the winds punishing the dollar is building, and there's a real danger that the currency will tumble out of control.

What has changed so much in just three weeks? Inflation in Europe has picked up and is now above the range the European Central Bank has said it will tolerate. There's a good chance the bank will raise short-term interest rates to 4.25% from 4% when it meets Thursday.

With U.S. interest rates on hold or headed lower, the result would be another big boost to the euro, another hit to the dollar, a continued move away from the U.S. dollar by central banks in Asia, Russia and the Middle East, and higher prices for gold and, more importantly, oil.

That's a lot of fallout from just one quarter-point increase, but the global economy and financial markets are so precariously balanced that any increase in wind velocity can cause massive damage.

So just how good a chance is the "good chance" that the European Central Bank will raise interest rates Thursday?

Here's the situation the bank faces. You be the judge.

Inflation on the uptick

Inflation jumped to 3.3% in Germany, the European Union's biggest economy, in October. That has led economists to raise their estimates for inflation for the European Union as a whole to 3%. Before the data from Germany, the consensus forecast for EU inflation stood at 2.7%.

Even 2.7% would have been worrisome: It would have been a slight advance from October's 2.6% and left the trend headed uncomfortably higher.

But 3% would present the bank with a crisis. Unlike the U.S. Federal Reserve, which doesn't publish a specific inflation target, the European Central Bank clearly states what level of inflation it finds acceptable. The bank has pledged to keep inflation "below but close to 2%." A 3% reading on inflation, the highest level in six years, would be way above that target.

Other signals point in same direction

And the 3% inflation figure isn't an isolated number. Other inflation indicators are pointing upward, too. Money-supply growth, which the bank uses to judge the likelihood of future inflation, has been running way above the bank's target of 4.5%. The bank calculates a 4.5% level of growth in the money supply is not inflationary.

But, the money supply grew by 12.3% from October 2006 to October 2007 -- the sharpest growth since July 1979. That was on the heels of an 11.3% year-over-year growth in September.

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The bank may be on the edge of the kind of inflationary spiral it fears. At the same time as German inflation is at a 13-year high, German unemployment has dropped to an almost-15-year low. That gives workers clout to negotiate pay increases above the inflation rate. The chief economist for Germany's DGB trade-union federation, the largest union federation in Germany, told a Berlin newspaper last week that inflation had negated the pay raises it had negotiated this year.

The country's 1.3 million-member civil-servants union has announced that it will look for a pay raise of 6% to 7% in 2008. Those are exactly the kind of raises that central bankers fear will set off an unstoppable inflationary trend, in which rising inflation prompts pay raises that in turn drive inflation higher. As if to confirm these fears, Germany's BASF (BFASF, news, msgs), the world's largest chemical maker, has announced it will raise prices by as much as 15%.

Balancing concerns

The European Central Bank has kept interest rates at 4% since June after raising rates nine times since December 2005. The bank has justified holding rates steady by pointing to fears that growth in the European economy might be slowing. But the bank may not be able to keep interest rates on hold much longer.

Why only "may not" instead of "certainly won't"? Because, like the U.S. Federal Reserve, the European Central Bank is keeping one eye on inflation and the other on the crisis in the debt markets. European financial institutions have suffered huge losses as a result of the meltdown of mortgage-backed debt. Barclays (BCS, news, msgs), for example, wrote down $2.7 billion in mortgage-backed assets Nov. 15. HSBC Holdings (HBC, news, msgs) set aside $3.4 billion in its third quarter to cover losses as a result of defaults on U.S. mortgages.

Continued: Credit crunch looms in Europe

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